Discretions for trustees in defined benefit schemes: Navigating flexibility beyond the funding and investment strategy

November 14, 2024

This article explores the circumstances where trustees can exercise discretion to diverge from the funding and investment strategy (FIS) agreed with the sponsor employer, providing insights into key sections of the DB Funding Code (the ''Code'') and suggesting best practices for trustees to balance flexibility with fiduciary duty.

As a general reminder, trustees must comply with the FIS regulations¹, and the Code includes TPR's guidelines for complying with those regulations. The closer the adherence to these guidelines the greater the likelihood that TPR will be satisfied that the FIS regulations have been complied with and the lower the chance of regulatory engagement.

However, the Code does anticipate circumstances in which trustees may wish to divert from the FIS, as further explained below

1. Material surplus and temporary growth allocation

Where schemes have reached or exceeded a targeted funding level, achieving a material surplus over the minimum low-dependency funding basis, the Code makes provision for some latitude in asset allocation to take advantage of growth opportunities. Specifically, as outlined in paragraph 325 of the Code, trustees can consider increasing allocations to growth assets even if this diverges from the core FIS. This strategy could be advantageous for schemes with a robust funding level, enabling trustees to adapt to favourable market conditions and enhance the scheme's asset base while positioning the scheme for its endgame target. Exercising this discretion will require trustees to evaluate associated risks as growth assets generally carry greater volatility compared to fixed-income investments. Trustees must ensure that any deviation aligns with the scheme's long-term funding objectives and does not jeopardise the security of accrued benefits.

2. The effect of frequent investment reviews

Part 3 of the Pensions Act 2004 envisages that there will be an actuarial valuation every year but permits a valuation every three years. Assuming actuarial reports are produced in the intervening years, TPR's expectation in the Code is for trustees to review their investments at more frequent intervals. and paragraph 326 of the Code acknowledges that more frequent investment reviews may see investment decisions in practice differing in the short term from the FIS. One example provided in the Code is of favourable conditions arising from market fluctuations - such as a rise in bond yields - which can offer trustees the chance to accelerate de-risking or strengthen the funding position.

Exercising this discretion will require a clear understanding of market dynamics and potential long-term impacts. Trustees should act prudently, documenting the rationale for such decisions and consulting advisors when necessary to align with FIS objectives. A structured yet responsive approach to favourable market conditions enables trustees to improve scheme outcomes without compromising their overarching fiduciary duty.

3. Employer disagreement and investment discretion

The FIS is a joint endeavour requiring input and agreement from trustees and the sponsoring employer. However, there may be occasions where the trustees wish to change the investment strategy within the FIS after it has been agreed (e.g. to take advantage of favourable market conditions) and the sponsoring employer does not agree.

The Code indicates that TPR will take a pragmatic approach in such cases. For example, paragraph 325 of the Code notes that there is a requirement for the employer to agree the FIS but notthe investment elements within the statement of strategy which require only consultation with the employer. In principle, this means that trustees should not be inhibited in exercising their investment powers where agreement cannot be reached, although there is an expectation in the Code that trustees and employers will work collaboratively and that the trustees will act appropriately and within the scope of the trust deed and rules. In practice, it seems that TPR will regard this type of divergence as a matter of last resort where all collaborative avenues have been exhausted and dependent on any trustee action passing an appropriateness bar.

Divergence on investment strategy without employer consent risks damaging the relationship between the sponsoring employer and trustees. Any employer resistance will likely be borne from a reasoned position such as competing corporate priorities or cash flow constrains. Where the trustees diverge without employer agreement, note should be taken of the employer's refusal reasoning and reasonable mitigation should be considered. This is especially the case where there may be a financial impact for the employer.

Trustees must be careful to document these decisions thoroughly, demonstrating both why the actions were necessary to support the scheme's health and adherence to the FIS's long-term objectives.

4. Addressing Employer Covenant Stress

The employer covenant is a cornerstone of risk management within DB pension schemes. Covenant strength can fluctuate due to broader economic conditions, market shocks, or temporary downturns in the employer's financial health. The Code notes that trustees must consider whether any employer stress will be short term or permanent and should plan accordingly.

Where the employer covenant shows signs of temporary weakening, trustees may choose to defer certain de-risking or rebalancing actions provided for in the FIS. This discretion recognises that employers may need time to stabilise or provide additional support, such as through contingent assets or guarantees.

However, if covenant deterioration appears permanent, trustees are expected to undertake a more comprehensive review of the FIS and adjust their strategy accordingly to minimise risks associated with employer insolvency or diminished financial backing.

5. Liquidity management for unexpected cash flow needs

The Code acknowledges that unforeseen liquidity demands can arise from unexpected benefit outflows, collateral calls, or other short-term cash needs and outlines scenarios where trustees may deviate from the planned FIS to prioritise liquidity.

For instance, trustees might need to sell liquid assets to meet sudden benefit payments, such as lump-sum commutations or transfers out. Similarly, derivatives-related collateral calls may require immediate cash availability. The Code advises trustees to have liquidity protocols in place, allowing for orderly asset sales and specifying an order of liquidations when urgent liquidity is required. Trustees are expected to prioritise liquidity under adverse market conditions, even if this temporarily disrupts the long-term asset allocation plan. This flexibility ensures trustees can meet scheme obligations without incurring penalties or compromising operational stability.

Balancing discretion with fiduciary responsibility

The Code anticipates that trustees will diverge from the FIS only in limited circumstances and only for the short term, Nonetheless, the ability to do this gives trustees an effective tool for flexibly managing a DB scheme. Trustees should exercise this discretion judiciously, and we would recommend that trustees follow these best practice points:

1. Clear documentation and rationale: Instances of divergence from the FIS should be documented with a thorough rationale, referencing specific Code provisions where possible and highlighting the anticipated impact on the scheme's funding position. This record will be essential for demonstrating transparency and regulatory & fiduciary compliance.
2. Regular reviews and updates: Trustees should periodically review any temporary deviations to determine if they remain appropriate. This ongoing assessment ensures the scheme stays aligned with long-term goals. Timeframes for review could be built into the initial record detailing the divergence.
3. Employer and member communication: Clear communication with the sponsoring employer and, where appropriate, members, is essential to explain any changes to the investment approach. This helps build trust and assures stakeholders that decisions are in the scheme's best interest.
4. Advisory support: Trustees should consult actuaries, investment advisors, and legal professionals where appropriate when considering significant temporary divergences. This collaborative approach helps validate the decision-making process and align actions with both regulatory and fiduciary standards.

Conclusion

The Code's framework for temporary divergence from the FIS equips trustees with essential tools to navigate the complexities of managing a DB scheme, especially as market and economic conditions fluctuate. By exercising this discretion responsibly, trustees can adapt their strategies to changing circumstances, reinforcing the scheme's financial health and safeguarding member benefits. These provisions underscore the importance of a balanced approach that respects the scheme's long-term commitments while accommodating the realities of day-to-day management. Trustees who apply these principles with careful judgment not only enhance scheme resilience but also fulfil their fiduciary duty in a way that benefits all stakeholders.

1. The Occupational Pension Schemes (Funding and Investment Strategy and Amendment) Regulations 2024 ↩